Balance of payments and exchange rate issues

1
Balance of payments and exchange rate issues

• Session 7
• Macroeconomics and the International Context
• MSc Economic Policy Studies
• Alan Matthews

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Balance of payments
3
Lecture objectives

• Describe and understand the balance of payments
  accounts
• Do international payments imbalances matter?
• Addressing international payments imbalances
• Reading McAleese Chapter 20

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Balance of payments

• The balance of payments is a set of accounts
  showing all economic transactions between
  residents of the home country and the rest of the
  world in any one year
• The current account in the balance of payments
  records all visible and invisible trade
• The capital account covers mainly capital
  transfers (EU grants and migrants net worth)
• The financial account in the balance of payments
  is a record of a countrys transactions in
  foreign financial assets and financial
  liabilities (often distinguishing between
  long-term and short-term flows)

CSO Student Corner on balance of payments
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Balance of payments statement

• Current account
• Goods trade (merchandise trade)
• Services
• Trading and investment income
• Current unilateral transfers
• Balance on current account
• Capital account
• Financial account
• Balance on financial account
• Foreign direct investment
• Portfolio capital
• Other investment
• Change in official reserves
• Net errors and omissions

• 2011, bn
• 37
• -2
• -31
• -1
• 1
• -0
• 6
• 11
• 27
• -33
• 0
• -7

Irish data. Source CSO Balance of
international payments release, Dec 2012
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Some definitions

• Merchandise trade similar to balance of trade
  account (see Trade lecture) but valued at f.o.b
  prices for both exports and imports
• Invisibles refers to balance of services trade,
  investment income and current transfers (net
  current receipts from EU and Irish Aid
  expenditure)
• Capital account transfers refer mainly to capital
  receipts under EU structural funds
• Financial account includes long-term capital
  flows (FDI and portfolio investment) and other
  flows which are mainly short-term loans and
  transactions in financial derivatives
• Reserve assets are non-euro denominated liquid
  assets and gold owned by the Central Bank

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Further definitions

• Sometimes distinction is made between autonomous
  and accommodating transactions in the balance of
  payments
• Former are seen as active transactions,
  responding to real changes in competitiveness
  conditions, while latter are passive
• Example consider reactions to an increased
  demand for imports
• Line is drawn under the basic balance, but
  increasingly less distinct as capital markets
  become more liquid

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Irish balance of payments trends
Year Merch-andise Invisibles Invisibles Invisibles Invisibles Balance on current account
Year Merch-andise Services Trading invest-ment income Current transfers Total Invisible Balance on current account
2002 35,442 -13,779 -23,664 707 -36,736 -1,295
2003 32,604 -11,091 -21,947 432 -32,606 -2
2004 31,423 -10,203 -22,481 393 -32,291 -867
2005 28,218 -9,303 -24,870 265 -33,908 -5,690
2006 25,031 -6,797 -24,033 -506 -31,336 -6,304
2007 19,811 -1,121 -27,825 -990 -29,936 -10,124
2008 23,811 -7,670 -25,155 -1,154 -33,979 -10,169
2009 32,469 -6,900 -27,907 -1,424 -36,231 -3,763
2010 35,751 -6,639 -25,918 -1,412 -33,969 1,782
2011 36,588 -1,810 -31,834 -1,159 -34,803 1,785
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Borrowers and lenders, debtors and creditors

• The balance of payments is a flow concept
• It shows whether a country is a net borrower or a
  net lender in any year
• A debtor nation is a country that during its
  entire history has borrowed more from the rest of
  the world than it has lent to it.
• A creditor nation is a country that has invested
  more in the rest of the world than other
  countries have invested in it.
• The difference between being a borrower/lender
  nation and being a creditor/debtor nation is the
  difference between stocks and flows of financial
  capital.
• Does it matter if a country is a debtor nation?
  Depends on how the borrowing has been used.

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International Investment Position

• The international investment position (IIP) is a
  point in time statement of the value and
  composition of the balance sheet stock of an
  economy's foreign financial assets (i.e. the
  economy's financial claims on the rest of the
  world) and its foreign financial liabilities (or
  obligations to the rest of the world).
• The change in the IIP between beginning and end
  of period is equal by definition to the current
  account balance over that period plus valuation
  changes reflecting changes in exchange rates and
  asset prices
• Note reconciliation is also difficult due to
  large BOP balancing item net errors and
  omissions

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Irelands IIP
Source CSO Quarterly International Investment
Position, Dec 2010
12
Source Lane, Dynamics of Irelands net external
position, SSISI, 2011
13
Source Lane, Dynamics of Irelands net external
position, SSISI, 2011
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Understanding the balance of payments current
account

• First, some national income accounting
• Recall total income Y is defined from
  expenditure side as
• Y C I G X M
• Y can also be defined as
• Y C S T
• In equilibrium, these two definitions are
  identical
• (I - S) (G T) (M X)
• Balance of payments deficit excess investment
  over savings plus government budget deficit

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Interpreting a current account deficit

• Two views
• A deficit is a sign that a country is spending
  more than it earns, a weakness which must be
  corrected by either/both reducing expenditure or
  switching expenditure from imports in favour of
  exports
• A deficit is a sign of strength because it means
  the country is sufficiently profitable to attract
  continued flows of foreign capital (focus on the
  basic balance)

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The importance of sustainability

• A country is said to have a balance of payments
  problem when the current account deficit and the
  accumulated international investment position
  have reached a level where continuance of the
  deficit is no longer judged sustainable
  McAleese
• Issues
• Time dimension
• Size of deficit in relation to GDP and debt
  position
• Method of financing of deficit
• Related to use of deficit (investment or
  consumption?)
• Growth position
• Sustainability a matter of market confidence

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Correlation between cost of CDS and current
account
Source http//www.voxeu.org/index.php?qnode/282
0 EA Euro Area
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Why an unsustainable current account deficit
matters

• Adds to cost of foreign borrowing
• Greater exposure to the volatility of
  international capital markets with potential for
  lack of confidence scenario (Asian crisis 1997)
• May induce excessivly large exchange rate
  depreciation
• Asset ownership moves into foreign hands
• Within the euro zone a countrys balance of
  payments should matter no longer, but it remains
  an important symptom of underlying problems

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Interpreting a current account deficit

• McAleese tale of three deficits
• US deficit
• Developing countries debt
• Deficits in Euroland

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Sustainability of the US current account deficit

• How sustainable is the deficit?
• Will it keep downward pressure on the US dollar?
• US deficit was running at around 6 of US GDP
• US dollar has depreciated by 40 relative to the
  euro between Jan 2002 and Jan 2004

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The US deficit is sustainable

• Some argue our large trade deficit (or
  current account deficit) is responsible for the
  fall in the dollar's value. They have it
  backward. It is the flow of foreign investment
  dollars (the capital account) into the U.S.
  economy that drives the trade deficit. The U.S.
  economy's higher return on capital than Europe or
  Japan for the last 20 years caused private
  foreign investors to buy U.S. stocks and bonds
  and other assets. In addition, foreign
  governments, particularly of China, Japan and
  other Asian states, have steadily increased their
  purchases of U.S. dollars as reserve backing for
  their own currencies.
• - Cato Institute economist Richard Rahn, Jan
  2004
• Note similarity to Box 20.1 in MacAleese

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The US deficit is not sustainable

• High productivity growth and booming stock
  markets in the 1990s drove a wedge between
  private investment and savings
• US household savings now fallen to 1 of GDP
• US fiscal policy now hugely expansionary
• Foreigners will lose their appetite to hold US
  assets, causing interest rates to rise and
  restricting demand

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Prospects for a soft US landing

• US economy insulated from the worst effects of an
  international financial crisis
• Because of its size
• The fact that most of its obligations are
  denominated in its own currency
• International role of the dollar underpins demand
  for it
• Damage may be felt as much by other countries as
  by the US

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Correcting a balance of payments imbalance

• Automatic adjustment mechanisms
• Start with adverse shock to exports
• -gt fall in demand for imports used as inputs to
  production
• -gt fall in aggregate demand leads to fall in
  imports
• -gt monetary factors such as fall in real balances
• -gt supply side adjustments through changes in
  relative prices of traded/nontraded goods

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Correcting a balance of payments imbalance

• Recall (I - S) (G T) (M X), problem is to
  reduce excessive (M-X)
• Expenditure reduction policies
• Increase S
• Reduce I
• Reduce G T through restrictive fiscal policies
• Expenditure switching policies
• Commercial policy (tariffs, etc)
• Improved cost competitiveness
• Exchange rate changes

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Relationship between global imbalances and the
financial crisis

• What role did global imbalances play in the
  crisis?
• One view excess savings drove down real
  interest rates, led to underpricing of risk
• Other view poor financial regulation was the
  cause
• Suominen 2010

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• Capital flowing uphill
• Driving by savings glut in surplus countries

Source King 2011
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Challenges for the G20

• How to address global imbalances when OECD
  countries are undertaking significant fiscal
  contraction?
• Excess of global savings
• Export-led growth model of China, Germany, Japan
• Currency appreciation by surplus countries?
• Alternatives?

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Exchange rates
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Motivations

• Ireland has a high share of trade outside the
  eurozone in which exchange rates play a crucial
  role in determining competitiveness
• Exchange rates are highly volatile
• The level of exchange rates can cause problems
  for business
• What determines the level and volatility of
  exchange rates?
• Reading McAleese Chapter 21

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US dollar/euro exchange rate
Euro depreciates
Euro appreciates
Source ECB Statistical data warehouse
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Sterling/euro exchange rate
Euro depreciates
Euro appreciates
Source ECB Statistical data warehouse
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The forex market

• Note its size!
• According to BIS, average daily turnover April
  2010 was 3.98 trillion (see Wikipedia entry)
• Made up of a series of interrelated markets
• Spot market
• Forward market
• Futures market
• Derivative markets
• Swaps and options
• Determines the relative values of different
  currencies

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The exchange rate

• The price of foreign currency (dollar, sterling,
  yen) in terms of domestic currency (euro)
• (viz. The price of apples how much do you have
  to pay in domestic currency)
• Suppose it costs US citizen 1.99 to buy 1 GBP
  in 1991 and twelve years later it costs only
  1.58 dollar has appreciated
• From UK perspective, I USD cost 50p in 1991 and
  63p in 2003 sterling has depreciated

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Impact of exchange rate on firms

• Advantages of a strong currency
• Makes imported raw materials cheaper
• Helps to control inflation
• Leads to lower interest rates
• Makes foreign assets cheaper
• Disadvantages of a strong currency
• Exporters lose price competitiveness
• Adverse impact on competitiveness may be
  moderated if leads to lower wage demands

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Effective exchange rates

• Bilateral exchange rates do not move together,
  so we need some method to summarise the overall
  strength or weakness of a countrys currency
• The nominal effective exchange rate (EER) is
  defined as the exchange rate of the domestic
  currency vis-à-vis other currencies weighted by
  their share in world trade
• Which currencies
• What weights?
• Significance of the base year
• Now called the Harmonised Competitiveness
  Indicator (HCI)

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Source The Economist March 24 2012
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Real Effective Exchange Rate

• Real effective exchange rate (REER) also takes
  account of price level changes between countries
• adjusts the nominal EER by the ratio of foreign
  to domestic inflation
• Used to assess change in competitive position of
  a country relative to its competitors
• Example
• Suppose currency of country A has depreciated
  over one year by 10 against currency of country
  B
• Suppose inflation rate in A is 7 and inflation
  rate in B is 2
• Then real depreciation (change in REER) is 10 -
  (7 - 2) 5
• Improvement in competitive position is 5, not
  the 10 suggested by the EER
• Now called the real HCI

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Source NCC, Irelands Competitiveness Scorecard
2012
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Exchange rate determination

• The exchange rate between two currencies is the
  price of one currency in terms of the other
• Express the exchange rate as the number of US
  dollars (price) per euro
• To determine the exchange rate we examine both
  the demand for and the supply of euros

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The demand for euro

• A derived demand
• Americans want euro
• in order to pay for European goods and services
  (exports)
• In order to pay for European assets including
  government bonds, equities and property

/
2
Depreciation
1
0.5
Euro
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The supply for euro
/

• A derived supply
• Europeans want dollars
• in order to pay for American goods and services
  (imports)
• In order to buy American assets including
  government bonds, equities and property

2
Depreciation
1
0.5
Euro
44
Exchange rate equilibrium
/
S
D
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Factors which shift the demand or supply curves

• Interest rate differentials
• Shifts in demands for assets
• Inflation differentials
• If EU goods become more expensive
• Growth differentials
• Stronger growth usually associated with stronger
  currency
• Speculation
• Expectations about future exchange rates
• Affected by above factors as well as stance of
  economic policy (budget deficits, balance of
  payments deficits, political outlook as well as
  market psychological factors)

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Reaching a new equilibrium

• Suppose euro interest rates rise
• Will increase demand for euro from US investors
• Will decrease supply of euro as EU investors also
  shift from US to EU assets
• Euro appreciates

• /

D2
S2
D1
S1
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Exchange rate equilibrium

• How can we tell if a currency is over-valued or
  under-valued?
• Is a currency likely to appreciate or depreciate
  in the near future?
• Answers provided by
• Purchasing Power Parity theory
• Balance of payments approach
• Asset market or portfolio theories

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Purchasing power parity

• PPP model holds that, in the long run, exchange
  rates adjust to equalise the relative purchasing
  power of currencies
• Draws inspiration from Law of One Price
• Arbitrage will ensure price levels converge
• Absolute PPP
• The exchange rate will be such as to make the
  general level of prices the same in every country
• Exchange rates between currencies are in
  equilibrium when their purchasing power is the
  same in each of two countries
• Unrealistic assumptions
• Difficulties with non-traded goods

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Purchasing power parity

• Relative PPP
• Changes in the exchange rate are determined by
  the difference between relative inflation rates
  in different countries
• Over the long run we would expect exchange rates
  to adjust to maintain purchasing power parity
• In other words, exchange rates should adjust to
  offset differences in the rates of inflation,
  maintaining a constant real exchange rate
• Do exchange rates adjust to maintain purchasing
  power parity?
• Yes, in the long run, but very slowly for reasons
  that are still unclear (see Rogoff JEL 1996)

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Purchasing power parity

• How is PPP calculated?
• The Economist Big Mac index
• People consume very different goods and services
  across countries
• Standard estimates produced every six months by
  OECD/Eurostat (OECD PPP database)
• OECD estimates in next chart compare the PPP of a
  currency with its actual exchange rate compared
  to US dollar. Green bars (top of chart) indicate
  currency is overvalued and thus expected to
  depreciate against he US dollar in the long run,
  and vice versa.

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OECD PPP estimates(relative to Euro)
Source University of British Columbia Pacific FX
Service
52
PPP uses

• Clearly there are significant discrepancies
  between PPP and actual exchange rates
• But can PPP be used to predict exchange rate
  changes?
• Poor empirical performance
• Real exchange rates not only determined by
  relative inflation differentials
• Real exchange rates can and do change
  significantly over time, because of such things
  as major shifts in productivity growth, advances
  in technology, shifts in factor supplies, changes
  in market structure, and commodity shocks
• Note objection Rapid productivity growth -gt
  higher inflation -gt currency appreciation
  (Balassa-Samuelson effect)
• But important long-run benchmark

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Balance of payments approach

• BoP approach focuses on relationship between
  trade/current account balance, modified to taken
  into account long-term capital flows, and the
  exchange rate
• BoP approach also allows ER to be influenced by
  real factors (economic fundamentals)
• Country with a persistent deficit is likely to
  devalue, country with persistent surplus likely
  to revalue
• Different to, but consistent with, PPP theory
• PPP -gt If country A has higher inflation rate
  than B, will run into a deficit and be forced to
  devalue

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Examples of economic fundamentals

• These are factors which can shift the supply and
  demand curves for a currency (see above)
• Changes in the growth rate
• Balance of payments (influencing expectations)
• Equity and bond market performance
• Size of budget deficits and public debt
• Governance and political stability

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Asset market (portfolio) explanations

• PPP and BoP approaches focus on role of ER in
  balancing flows of foreign exchange
• Modern approach emphasises role of ER in
  balancing the supply and demand of domestic and
  foreign assets
• Exchange rates adjust to reflect differences in
  the rate of return on assets (bills and bonds) in
  different currencies
• It is differences in the expected total return
  which is relevant. This comprises the interest
  rate on foreign assets plus the capital gain
  (loss) from a appreciation (depreciation) of the
  foreign currency

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Asset market explanations

• Expected exchange rate changes (and hence the
  expected capital gains or losses from investing
  abroad) influence decisions
• Because expectations are influenced by news,
  and news is unpredictable, so are short run
  fluctuations

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Interest rate parity

• What determines international capital portfolio
  movements?
• Difference between interest rates at home and
  abroad
• Expectations about future exchange rates
• Interest rate parity describes the relationship
  between forward exchange rates, spot exchange
  rates and interest rates between two countries
• Rates of return on comparable assets should be
  equal around the world, implying that exchange
  rates adjust so that difference between interest
  rates is zero.
• It relies on the markets tendency to correct
  itself through arbitrage
• Two versions
• Uncovered parity
• Covered parity

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Uncovered interest rate (UIP) parity

• If US risk-free interest rate is 4 and euro rate
  is 2, why do fund managers not switch into
  dollar assets?
• Domestic interest rate less foreign interest rate
  expected change in exchange rate (Uncovered
  interest rate parity)
• Assumes
• Perfect capital mobility
• Equal risk on home and foreign bonds
• If interest rate differential is greater than the
  expected change in spot rates, potential for
  arbitrage

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Covered interest rate (CIP) parity

• Borrow money in one currency (low interest rate),
  use to buy bonds in second currency (higher
  rate), and protect (cover) against exchange rate
  movements by buying the first currency forward
• Interest rate differences should equal the
  forward premium (covered interest rate parity)
• Forward exchange rate is a proxy for exchange
  rate expectations. UIP builds on CIP by assuming
  that market forces ensure the forward exchange
  rate is equal to the expected future spot
  exchange rate
• However, forward exchange rate is not a good
  (although unbiased) predictor of the spot rate
• Underlines that exchange rates are affected by
  shocks which are inherently unpredictable

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Empirical performance of interest rate parity

• Does (uncovered) interest rate parity hold?
• Hard to measure, since requires information on
  expectations and on relative risk of bonds
• Cause or effect?
• if it holds, does it mean that interest rate
  differentials determine exchange rate changes, or
  vice versa?

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One effort to measure desired equilibrium
exchange rates
Cline and Williamson, 2012, Peterson Institute
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Summary

• Exchange rate movements are an important
  determinant of competitiveness
• Although we can understand the factors which move
  exchange rates, their movement is very hard to
  predict
• Modern theory emphasises how the importance of
  the balance of trade in goods and services (the
  real economy) in influencing exchange rates is
  overwhelmed by international capital movements,
  whose movement is very hard to predict
• Firms can adapt strategies to insulate partially
  against exchange rate movements, but they are
  partial and costly
• International coordination of exchange rates?

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Euroland issues
Source EEAG report 2012
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Source EEAG report 2012
65
Source EEAG report 2012
66
Restoring Irelands competitiveness

• Within the EU, commercial policy and exchange
  rate changes are ruled out
• Expenditure reduction policies (i.e. fiscal
  tightening) can lead to severe economic
  contraction and rise in unemployment
• Reduction in nominal wages required to mimic a
  real devaluation internal devaluation - , but
  how to achieve?